Every business must grow their sales to remain viable and to generate consistent earnings. If your receivables grow at a faster rate than your sales, however, you’ll eventually run short on cash. When you invoice clients and wait for customers to pay, you are extending credit to your clients. This is a critically important point that you need to keep in mind.
The faster your receivables grow, the more cash is tied up in your receivable balance. At some point, you may not be able to generate sufficient cash to run your business. You’ll have to either borrow money or sell ownership in your business to raise cash.
You can minimize the risk of a cash shortage by planning for your sales and receivables growth. Use these tips to manage your receivables and cash flow your business.
How much cash do you need?
Creating an annual budget will help you address many of your business growth issues. Let’s assume that you manufacture and sell sporting goods equipment. You sell your products to sporting goods stores and through your website.
One component of your budget is a projected income statement. Assume that you estimate $500,000 in annual sales. Your projected cost of sales total $400,000, and you estimate a gross profit of $100,000. If you think about your cost of sales on a monthly basis, you’ll need more than $33,000 in cash just to manufacture and ship your products to customers.
Estimating cash flow
Let’s expand on that $33,000 monthly cash flow for production. Obviously, you’ll start the year with a balance in your cash account. Assume that your starting balance is $10,000, for example. You have some cash at the beginning of January to produce your product, but you’ll need more cash during the month.
You also need to make some assumptions about receivables. Estimate what percentage of your total sales will not be immediately paid in cash. Assume, for example, that 70% of your clients to pay sometime after you give them an invoice. At $500,000 in annual sales, that’s a total of $350,000 in new receivables during the year.
Your business plan should also estimate how quickly clients will pay their receivables. $350,000 in new receivables is nearly $30,000 a month. If the average customer doesn’t pay for 45 days, you won’t collect all of your early January sales until mid-February.
Take all of this information and load it into a spreadsheet. You’ll start to get a clear picture of how much cash you need, based on all of your assumptions. Obviously, your actual results will be different from your budget. The next step is to increase your cash collections once your fiscal year begins. Here are some strategies to do that.
A business may offer discounts for several reasons. You can offer a quantity discount to drive more total sales, for example. While this type of discount can increase sales, it does not mean that you’ll collect cash faster.
To collect cash quickly, offer a discount for paying on a timely basis. Say, for example, that you offer a 5% discount for all invoices paid within 10 days. You’re making the calculation that collecting 95% of an invoice in 10 days is better than waiting 45 days to collect 100%. In other words, you’re willing to give up 5% of your revenue to collect cash about 30 days faster than average.
Deposits and installment payments
You can improve your cash inflows by asking for a deposit when a customer places an order. Your customers probably make deposits for other products and services they buy, so your request is not unusual. Many service-oriented businesses (attorneys, consultants) ask clients for retainers. A retainer is an advance payment for the hours and costs that the professional will incur for the client.
A deposit or retainer is a reasonable request, because the payment offsets costs that you will incur to work for the client (labor, materials, etc.). By asking for payment, you avoid the need to pay for those costs out of your own pocket.
Companies that work on long-term projects often require installment payments. The best example is a construction project that takes months or even a few years. The contract for the project will require the client pay a portion of the total job’s price, based on certain completion measurements. For example, the customer may have to pay 30% of the total project’s price when the company has incurred 30% of the cost to build the project.
An installment agreement allows the business to collect some of the total receivables during the project. This reduces the need for the company to use its own cash to complete the work. Deposits, retainers and installment contracts can improve your cash flow and help you operate your business.
Accounts receivable is an asset account, because the balance represents an amount you will eventually receive in cash. In some cases, you can use your receivables as collateral for a loan through factoring.
Assume that you manage Levi’s Jeans, for example. You’re shipping $10,000 of jeans to your client, Old Navy. You’ve been doing business with Old Navy for years and they’ve always paid their invoices. Typically, Old Navy pays you in 45 days.
Rather than wait 45 days, you approach a factoring company. The factoring business loans you $10,000 and charges you a fee. When Old Navy pays the invoice, they now send that payment to the factoring company. You get your cash sooner, and the Old Navy receivable serves as collateral for your loan. Since Old Navy always pays their invoices, the collateral is secure.
Follow up and collections
The most important tool for collecting receivables is your procedures manual. Your business should have a written procedure for every routine task you perform. You should document the task performed, and the person responsible for that task. Here are some steps you need to have in place for collecting receivables.
You should monitor your receivables by reviewing an aging schedule. This schedule lists all of your receivables by dollar amount and the invoice date. You also need a follow up policy for receivables.
Say, for example, that you email all customers when an invoice is more than 45 days old. At 60 days or older, you make a phone call and ask for payment. Each day, you generate your aged receivables schedule and follow up. Regardless of what steps you take to speed up cash flow, this is the most effective way to collect your cash.
Finally, you may need to make the hard decision to stop doing business with certain customers. If a client consistently pays late, you may decide to end the business relationship. Sure, you’d love to have the business, but these clients are keeping your cash tied up in receivables.
Clients who pay late also require follow up, which eats up your time. Some customers are simply too difficult to manage- so let them go and find a better client who pays on time.
Growing your sales is what business is all about. It’s validation that you’re solving a problem for your customers by providing a great product or service. However, you need to stay on top of your receivables. Use these tips to manage your receivables and grow profitably.